Stablecoins — Why are They So Popular?

Stability is a tricky matter. While experienced traders have learned how to embrace the beauty of volatility and make a profit out of it, your average Joe is not so keen to put his hard-earned money at stake. Cryptocurrencies have made their way into the lives of many and yet, they still struggle to fulfill one of the primary purposes of money — you cannot really buy real-world stuff with them.

Think of this: unless you and your landlord are strong bitcoin supporters, you won’t be able to pay your rent with BTC because neither of you is sure what it’s gonna be worth tomorrow.

It is also not very reasonable to save for a rainy day using only your crypto, because you might not even be able to buy an umbrella. That being said, we don’t want to put cryptocurrencies down in any way, but simply aim to point out two major crypto problems that need to be solved.

Stablecoins were created in an attempt to give crypto the qualities that it’s lacking, and make it more valuable and usable. Another step towards mass adoption.

How it Works

How do we bring about stability in the shaky crypto sphere? To understand this, we have to look at what makes fiat currencies relatively stable. Fiat is backed by reserves and central authorities, like banks, that make certain decisions according to the current market situation. Fiat currencies are also pegged to other assets such as gold or other bonds that act as collateraland help control the price and if something out of ordinary happens, the banks will step up and manage the supply and demand.

So the question is, how do you do something like this, but with crypto?

Currently, there are 3 ways of powering stablecoins.

Fiat-collateralized

This type of stablecoin is pegged to the USD so that 1 coin equals 1 USD. This means that the company behind it is supposed to have a solid bank account that has enough money to cover every single coin that has been issued. By the way, that’s one of the main differences between stablecoins and other crypto — there is no limited amount of stablecoins, it always varies according to the market situation. The most popular fiat-collateralized coin is Tether, USDT. There have been lots of rumors surrounding Tether suggesting that it’s just another Ponzi-scheme and they do not actually own the necessary amount of money to back up their coin. Although quite a few investigations have been made, nobody can be sure that Tether is 100% clean.

They are fully controlled by the company behind them and, therefore, centralized.

There is no way to prove that the reserve actually exists.

We go back to depending on central banks and governments because of the USD peg.

Crypto-collateralized

The other type of stablecoin is pegged to crypto and usually, it’s Bitcoin or Ethereum. That might sound a little bit confusing because crypto is already super volatile and that’s why stablecoins were invented in the first place, but their creators came up with a solution. The idea is to provide bigger collateral: for example, in order to issue 1 stablecoin, that traditionally costs 1 USD, you have to provide 2 USD worth of ETH.

One of the most successful crypto-collateralized stablecoins is Dai, by Maker DAO. We’ve dedicated a whole article to them (and btw you can always get some Dai in your Lumi Wallet) and explains the mechanism that helps them deal with drastic price changes. One of these mechanisms suggests that borrowing Dai becomes more expensive when the price is below target. At the same time, if the price goes above the target — creating new Dai becomes cheaper, and this also affects the total amount of existing Dai.

Critiques

The single but major critique is that it is still unrealistic to peg crypto to crypto as they are way too volatile and even with a significant reserve rate their stability is rather questionable.

Non-collateralized

As you might have guessed by the name non-collateralized stablecoins have no collateral or reserve. Instead, they use specific algorithms that are supposed to protect them from the volatility. This can be done using smart contracts that will be activated in the case that the coin’s price goes up or down and decreases or increases the overall amount of coins and it works similar to a central bank system where they take actions and print banknotes to maintain price stability.

Critiques

Some say that those type of stablecoins may work in the short term before demand stops growing, and even call it ‘free money that will eventually depreciate when the growth ends.’

And what is there for their creators, how do stablecoin companies make money?

Some companies set up fees for the people who trade their coins. Another way is to use a stablecoin solution as a marketing instrument and encourage potential clients to use their other services or products. Take, for example, Coinbase and USDC. Business models are quite different and there’s always room to maneuver.

The Bottom Line

The popularity of stablecoins is mainly explained by the fact that they bring stability to the uncertain crypto market scene and make digital assets more tradeable and like real money. A lot of VC money went into stablecoin development in 2018 because of the perspectives that their business models can offer. However, skeptics are less than thrilled, saying that volatility is only a temporary problem of crypto and it will eventually be solved anyway, so there won’t be any need for things such as stablecoins.

We’d say it all depends on the company behind the coin and the goals they set for themselves.

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